What is Debt Consolidation and How Does Debt Consolidation Work?
By Maddy Scheckel Are you drowning in debt?
If so, you’re hardly alone.
On average, Americans owe $90,460, and many are asking the same question: How do I get out of this?
The answer: A mix of discipline and strategic thinking.
Yes, avoiding unnecessary spending is the first order of business – but there are other strategies that can help.
One of the most useful is called debt consolidation.
So, what is debt consolidation? And how can you make the process work for you?
It’s time you got the lowdown on this life-changing financial strategy.
What is Debt Consolidation?
Debt consolidation allows you to combine different debts into a single monthly payment.
Basically, you’re taking multiple debts – whether from credit cards, medical bills, or student loans – and combining them all together.
Consolidating your debts can make your financial life simpler and improve your payoff terms. With lower interest rates, lower monthly payments, or both, you’ll have an easier time paying off your debts and strengthening your finances.
Imagine you’re facing debt from several credit cards.
Not only is meeting the payments a stressful endeavor, but you’re also getting hit with high-interest rates.
Debt consolidation allows you to take out a single loan to replace the confusing mix of rates and payments.
Source: Unsplash
How Does Debt Consolidation Work?
You can’t answer the question, “What is debt consolidation?” without understanding how the strategy works.
Despite the name, the existing loans aren’t actually compressed into a single loan. Instead, they’re replaced by a new loan that’s used to pay them off.
The process looks like this:
Step 1: Work with a lender to secure a loan that will cover your existing debts.
Step 2: Use the money from the loan to pay off those debts.
Step 3: Work towards paying off the new loan – which requires a single monthly payment.
So, what is debt consolidation?
In a sense, it’s actually debt replacement – replacing those debts you’re paying off separately with a single, comprehensive loan that covers it all.
Types of Debt Consolidation
Debt consolidation isn’t a one-size-fits-all solution. There are different types of debt consolidation, and you’ll have to think carefully about which is right for you.
1 – Debt Consolidation Loans
Debt consolidation loans are designed specifically to help people consolidate their existing debts.
A lender – which could be a peer-to-peer lender or a traditional bank – will offer a single loan as part of a comprehensive payment plan.
You’ll then use the proceeds from the loan to pay off your outstanding debts. Some lenders will even pay off the outstanding debts directly – a helpful move that makes your life easier.
Debt consolidation loans usually last anywhere from 1-10 years, and you can often use them for debts up to $50,000.
2 – Balance-Transfer Credit Cards
Balance-transfer credit cards take the debt from multiple credit cards and put it under a single card.
This can save you a lot of money on interest payments – as long as you pay off your debts quickly.
What makes balance-transfer credit cards so appealing is that they often give you an “introductory period,” and during that time, you won’t pay any interest.
Imagine you’ve got large balances on three different credit cards, and each of those cards charges a hefty interest rate. By switching to a balance-transfer credit card, you can put an immediate stop to the interest that’s ballooning your debt.
Balance-transfer credit cards will charge interest after the introductory period is over – and the rates can be quite high. That’s why they’re best for people who can pay off their debts quickly – preferably before the introductory period ends.
3 – Home Equity Loans
Home equity loans, aka “second mortgages,” allow you to borrow money by tapping into the equity you have in your home.
If you’re a homeowner, your property is likely your most valuable asset. By staking that asset as collateral, you can get a loan with relatively low-interest rates.
When you take out a home equity loan, you’ll receive an immediate lump sum – which you can then use to pay off your existing debts.
Assuming the interest rate on the home equity loan is lower than the rates from your existing loans, you’ll end up coming out ahead.
This sounds like an easy win – but it’s worth remembering that you’re risking a foreclosure on your home if you fail to meet payments. That’s why this maneuver is best for people with a steady income and considerable equity in their home – meaning they’ve paid off a significant portion of their mortgage.
4 – Home Equity Lines of Credit (HELOCs)
Home equity loans of credit (HELOCs) represent a special type of home equity loan – a type that provides revolving credit rather than an immediate lump sum.
As with any home equity loan, you’ll qualify by proving you have equity in your home and offering your property as collateral. Unlike other home equity loans, you’ll receive funds on-demand over the course of the agreement.
You’ll have access to this credit line for a certain “draw period,” – which is usually about ten years.
You’ll also have a “repayment period” for paying back the loan – which typically lasts around 20 years.
You can draw from your credit line to pay down your existing debts, but you’ll need to make sure you meet the HELOC payments. As with all home equity loans, you’re at risk of losing your house if you fall behind.
5 – Student Loan Refinancing
Student loan refinancing allows you to consolidate your student debt within a single loan.
If you’re currently facing several loans with high-interest rates, you could replace them with a consolidated loan that offers better terms.
Lenders will make sure you meet eligibility requirements before refinancing your student loans.
You’ll also lose access to deferment, income-driven repayment, and other perks offered by the federal government. Despite these downsides, refinancing can be a great option for ex-students facing multiple high-interest loans.
Source: Unsplash
Pros and Cons of Debt Consolidation
Financial decisions are rarely win-wins – and debt consolidation is no exception. Here are the pros and cons to consider before making a decision:
Pros:
- Lower interest rates. This is often the most appealing part of debt consolidation. With lower rates, you’ll have an easier time making payments.
- Pay off your debts more quickly. If you combine your debts into a single loan with more favorable terms, you’ll likely be able to pay them off sooner.
- Convenience and simplicity. Being in debt is stressful – especially when you’re juggling multiple monthly payments. Having a single payment will make your life a whole lot easier.
- Boost your credit score. When you consolidate your debts, you often end up lowering your “credit utilization ratio.” This means you’re using less of your available credit – which results in a higher credit score.
Cons:
- Risking your collateral. If you’re borrowing money against your home or another asset, missed payments could result in you losing the asset altogether.
- Upfront fees. Debt consolidation often brings immediate costs, including closing fees, origination fees, and balance-transfer fees.
- Potential increase in the cost of debt. Debt consolidation can decrease or increase the cost of debt depending on the structure of the new loan. Even a loan with a lower interest rate can end up costing more if you take longer to pay it off.
Commonly Asked Questions About Debt Consolidation
So I’ve answered the big question: What is debt consolidation? But that’s not all you need to know.
You’ve got questions. I’ve got answers. Let’s work together to get your finances back on track.
Is Debt Consolidation a Good Idea?
Debt consolidation is often a good idea – but it depends on your financial circumstances. If you’re dealing with multiple high-interest loans, then consolidation could help you pay off your debt under more favorable terms – that is, with lower interest rates or lower monthly payments.
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Debt Consolidation Vs Personal Loan
- Debt consolidation is a strategy for paying off several different debts by taking out a single, new loan to replace them.
- A personal loan is money borrowed and then paid back with interest. Many people conduct debt consolidation by taking out a personal loan.
Why Is Debt Consolidation Helpful?
Debt consolidation is helpful because it simplifies your debt repayment efforts. You’ll only have to meet a single monthly payment instead of several, and the interest rate will likely be lower.
What Is a Disadvantage of Debt Consolidation?
One disadvantage of debt consolidation is that it doesn’t address the underlying habits that put you into debt in the first place. If overspending continues, you could fail to meet payments on the consolidated loan and go deeper into debt.
Who Qualifies for Debt Consolidation?
Qualification for debt consolidation depends on your credit standing. If you have a good credit score, you’ll probably qualify for a debt consolidation loan. If not, you can still work with lenders to get debt consolidation loans for bad credit.
Does Consolidating Your Debt Affect Your Credit Score?
Debt consolidation can improve your credit score. That’s because consolidating debts within a single loan often decreases your credit utilization ratio. When credit bureaus see that you’re using a smaller portion of your available credit, your credit score increases.
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How Long Does It Take to Get a Loan or Line of Credit for Debt Consolidation?
Getting a loan or line of credit for debt consolidation usually takes 7-30 days, depending on the lender and your financial situation. During this time, the lender will decide whether you’re eligible for a loan and what types of terms they’re willing to offer.
What Are the Risks of Debt Consolidation?
The risks of debt consolidation include falling deeper into debt, paying higher interest rates, and – in the case of home equity loans – losing your property. With these risks in mind, it’s important to only consider debt consolidation if you’re prepared to stay disciplined.
What Is a Debt Consolidation Example?
Let’s say you’ve got debt from three different credit cards, each with a high-interest rate. If you take out a debt consolidation loan, you can then pay off the credit cards immediately with the proceeds. Instead of making three payments, you’ll make one to your new debt consolidation lender.
When Should You Consolidate Debt?
You should consolidate debt if you have multiple high-interest loans and you’re committed to financial discipline. A debt consolidation loan can help you lower your interest rates – but irresponsible spending after consolidation could see your debts grow even larger.
